Microsoft: A Great Company But An Overvalued Stock

| About: Microsoft Corporation (MSFT)

Summary

The business of Microsoft is in good shape.

The stock price has surged almost 40% in the last year and now seems to be overbought.

DCF and DDM models show the fair price of the stock is lower than the current price.

Microsoft's (NASDAQ:MSFT) stock has shown solid gains over last few years, with an increase of 39% over the last year. While I believe Microsoft does a decent job in terms of business ventures, I still believe the stock is currently overpriced. To support my opinion, I use various valuation techniques, including DCF and DDM models, to estimate a fair value of the stock.

Stock Price

(Source: Graphiq.com)

Promising business

First of all, it is important to mention that Microsoft's business is indeed solid and has a promising potential. Thus, recently unveiled Microsoft Laptop, with its great design and good specs, targets a compelling market of students, the field that has until recently been dominated by Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) Chromebooks.

Moreover, the cloud business is soaring, evident by $6.8 billion of revenue in Q3 2017. Overall, the intelligent cloud revenues increased by 11% year-over-year, with a hefty 93% in Azure. Venturebeat emphasizes this:

Two quarters ago, Microsoft's commercial cloud business exceeded a $10.0 billion annual run rate. This quarter, the company shared it now sits at $15.2 billion. The projection for this number is still $20 billion by 2018.

In addition, Microsoft has a very encouraging exposure to blockchain technology. I already wrote about this topic in more detail in one of my previous articles. A more recent example is the collaboration of Microsoft and Accenture (NYSE:ACN) on providing a "blockchain-based digital ID network." The project aims to provide people, especially refugees, with the ability to be easily identified by the help of software, thus having an access to public services. Reuters offers an example:

For example, refugees who have fled their country leaving behind birth or education paper certificates would still be able to provide proof of those credentials through the system.

Overall, it is clear Microsoft is on the right track and is likely to remain a successful corporation in the near future. However, the valuation models show it is not the time to invest in the stock.

Analyzing market comparables

First of all, it is important to make a comparative analysis of MSFT stock. While it is not easy to find a similar corporation to make the analysis valuable, it is still possible to see where Microsoft stands in comparison to other tech giants. Thus, it is identified that the PEG and P/E ratios are almost the highest among the peers. The only company that has a higher P/E is Adobe (NASDAQ:ADBE), which, in turn, shows a very reasonable PEG ratio of 0.8. This suggests that MSFT stock can be currently overvalued.

Data provided by YCharts and Finviz.com

PE ratio

(Source: YCharts)

DCF analysis

To strengthen the analysis, I use discount cash flow model to value the company.

My analysis is based on the following assumptions:

1. The average annual revenue growth over the horizon period of five years is estimated to be around 5.5%, with a 4.5% increase in 2017 and 7.9% increase in 2018. The numbers fully comply with the average analysts' expectations provided by Yahoo Finance.

The growth from 2019 to 2021 is expected to be on the level of 5%.

2. EBITDA margin will level off on the level of 34%. This is higher than 2016 EBITDA margin of 32.3%. At the same time, high margins are possible due to expanding cloud business.

3. An average growth in PP&E will be around 15.6%, with a decrease to 12% in 2021.

4. The effective tax rate is estimated on the level of 22.5%.

5. Then goes the WACC.

The after-tax cost of debt is 3.5%. The cost of equity capital (11.1%) is calculated using CAPM, with 0.99 beta, 2.2% risk-free rate, which is the current U.S. 10-year bond yield, and 9% market premium. The WACC is, therefore, estimated to be 10.5%.

WACC

Here is the operating and balance sheet data used in the modeling:

DCF

As a result, the model shows $515.15 billion equity value under the base scenario, which assumes EV/EBITDA multiple will decrease to the level of 15.1 by the end of the horizon period (2021), which would be still higher than this multiple of Apple (NASDAQ:AAPL), which is 11.5. In this case, the fair value of the stock is $66.7. Under the pessimistic scenario (14.1x EBITDA terminal value), equity value is $489.3 billion or $63.4 per share, representing more than 9% downside potential for the stock. The sensitivity analysis shows a range of possible outcomes that will be driven by actual results of the corporation. Therefore, the fair price range is $65.1-68.4, which represents (-8)-(-3)% from the current price ($70.8 as of 19 June). As a result, DCF model shows the stock is overvalued.

DDM analysis

In addition, I use dividend discount model to value the stock.

The assumptions are the following:

1. The annual growth rate of dividends will be 10% over the horizon period, which is calculated using the average return on equity of 23% and an average retention ratio of 45% (the data by YCharts).

2. The terminal cost of equity is 8%, terminal growth is 4%, the payout ratio will increase to 75%. From this, terminal ROE is 16%.

3. The cost of equity is 11.1%, which was calculated in the previous section.

As a result, the model shows a fair price of the stock is $62.97, which complies with the pessimistic scenario of the DCF model. Therefore, DDM model also shows Microsoft's stock is overvalued.

Conclusion

Microsoft's stock has surged in the last year and is up almost 40%. The business looks attractive, and the growth rate for the cloud segment is impressive. However, I think the stock is now in overbought territory. Thus, Microsoft trades at premium PEG and P/E multiples. Moreover, DCF and DDM models show the fair price of the stock is lower than the current price. As a result, cautious investors should wait for a pullback to warrant an investment in the company.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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